Northrop Grumman (NOC 0.38%) likes its stock. I mean, really likes it.
In December last year, the defense major's board of directors roughly tripled the amount of Northrop Grumman stock that the company was authorized to buy back, to $3.8 billion. Then, just last week, the company further announced that it will "accelerate" that buyback plan by buying a $1 billion slug of its shares all at one go.
Inquiring investors want to know: What's the hurry? Why the sudden inspiration to buy so many shares, and all at once?
NYSE: NOC
Key Data Points
Northrop Grumman 2024 earnings report
You don't have to look far for the answer. On Jan. 25, Northrop Grumman issued a Q4 earnings report that bludgeoned its stock, which fell more than 6% on Earnings Day. Despite growing its Q4 sales 6% year over year (and its full-year sales by 7%), Northrop flipped from earning $13.46 per share in Q4 2022 to losing $3.54 per share in Q4 2023. Full-year profits got cut more than in half, falling 57% to just $13.53 per share.
Northrop Grumman was quick to explain the loss as arising out of two big charges taken in Q4 2023: First, the company had to take a $7.68-per-share charge for cost overruns in its fixed-price contract to build B-21 stealth bombers for the U.S. Air Force. The company also took a charge of $2.08 per share to account for changes to the value of pension fund, which it described as a "mark-to-market" or MTM expense.
Together, that's $9.76 per share in profits foregone in the quarter. But even if the company hadn't taken those charges, its profit for the quarter would have been only $6.22 per share -- a year-over-year decline of more than half. So those earnings were still pretty lousy for Northrop. It's also worth pointing out that Northrop Grumman's historically high profit margins decline in two of its three business divisions that are not tied to the B-21 program (mission systems and space systems), and only increased in the company's smallest division, defense systems.
Yet despite all this, Northrop CEO Kathy Warden characterized her company's Q4 performance as "a strong finish to the year" -- and just a few days later began buying back shares hand over fist. Why was that?
Bad news, good news
Well, obviously, the bad news was that Northrop lost money in Q4. But the good news was that sales grew in the quarter -- and, in fact, grew even more strongly than management had forecast -- and that 2023 free cash flow (FCF) came in quite strong, and in fact toward "the high end of our guidance range."
After deducting capital spending from operating cash flow, Northrop Grumman generated positive FCF of $2.1 billion in 2023. Furthermore, management forecast that FCF will grow to at least $2.25 billion in 2024, and potentially as high as $2.65 billion, which would be 26% year-over-year growth. Earnings for the quarter, adjusted for pension fund contributions, could meanwhile bounce back 84% to as much as $24.85 per share.
That will be quite an accomplishment if it happens, given that Northrop is guiding for no more than 5% sales growth in 2024.
Should you buy Northrop Grumman stock?
Given these expectations for a quick turnaround in 2024, it actually makes some sense that Northrop Grumman might want to buy back shares today, when sentiment is so negative and shares are relatively cheap, rather than later, when sentiment hopefully improves, and shares become more expensive.
But even so, I'm not sure it's a good idea.
Consider: Valued on trailing free cash flow, Northrop Grumman has an enterprise value-to-FCF ratio of about 40. Valued on projected 2024 FCF, this valuation drops a bit -- but only to about 30.2 in the best-case scenario.
Granted, taking everything management says at face value, Northrop may be able to achieve FCF at a sustained rate of 15% annually over the next three years. But even viewed most charitably, the best valuation I can get on this stock is an EV/FCF/growth ratio of 2.0, which is about twice what a value investor like me would consider a fair price for the company.
I'm afraid that, on this one, I'm going to have to side with the folks selling Northrop last week. Northrop Grumman is no value stock. In fact, it's probably even a "sell."
